All about ALLL

Loan loss reserves are funds set aside to cover bad loans. According to the American Institute of Certified Public Accountants (AICPA), the allowance for loan losses should represent an amount that, in a bank management's judgment, approximates the current amount of loans that may not be collected. Thus, the purpose of loan loss reserves is to be forward-looking in order to expected future losses. Loan loss reserves contrast with bank capital requirements, which are in principle, to be used to cover unexpected losses.

Banks add to their loan loss reserves through periodic loan loss provisions. This provision is charged against current earnings. The loan loss reserve account acts as a contra account (deduction from the bank's outstanding loans) to give a more accurate profile of a bank's assets and earnings potential. Although, strictly speaking, loan loss provisions should be based solely on expected losses, the amount of earnings that is allocated for loss provisioning may be influenced by a number of factors.

In December 1986, the Securities and Exchange Commission (Commission) issued Financial Reporting Release No. 28 (hereafter referred to as FRR No. 28). In FRR No. 28, the Commission noted inadequate documentation of procedures for performing detailed reviews of loan portfolios and subsequent determination of allowances and provisions for loan losses. The Commission also indicated its expectations to find "that the books and records of registrants engaged in lending activities include documentation of: (a) systematic methodology to be employed each period in determining the amount of loan losses to be reported, and (b) rationale supporting each period's determination that the amounts reported were adequate."

Since issuing FRR No. 28, the Commission has continued to observe banks with little or no documentation of their allowances for loan losses. Bank management should document significant favorable or unfavorable trends in the quality of their loan portfolio by way of reasoned analysis. Also, if management deems a particular loan is impaired the loan should be reconcilable and documented with management's ultimate decision to provide or not to provide for any loss on that loan.

In its October 1994 Report to Congressional Committees, Depository Institutions: Divergent Loan Loss Methods Undermine Usefulness of Financial Reports (GAO Report), the GAO reported its findings resulting from its review of the loan loss reserving practices of 12 depository institutions. One of the principal findings from the GAO Report was most of the institutions reviewed included large supplemental reserves which were not supported by sufficient evidence or were otherwise not linked to an analysis of loss exposure. The GAO noted: "Such use of unjustified supplemental reserves can conceal critical changes in the quality of an institution's loan portfolio and undermine the credibility of financial reports."

As indicated in the AICPA Audit and Accounting Guide, Banks and Savings Institutions (Audit Guide), "While different institutions may use different methods, there are certain common elements that should be included in any [loan loss allowance] methodology for it to be effective."

• Include a detailed analysis of the loan portfolio, performed on a regular basis;
• Consider all loans (whether on an individual or group basis);
• Identify loans to be evaluated for impairment on an individual basis under SFAS No. 114 and segment the remainder of the portfolio into groups of loans with similar risk characteristics for evaluation and analysis under SFAS No. 5;
• Consider all known relevant internal and external factors that may affect loan collectibility;
• Be applied consistently but, when appropriate, be modified for new factors affecting collectibility;
• Consider the particular risks inherent in different kinds of lending;
• Consider current collateral values (less costs to sell), where applicable;
• Require that analyses, estimates, reviews and other loan loss allowance methodology functions be performed by competent and well-trained personnel;
• Be based on current and reliable data;
• Be well documented, in writing, with clear explanations of the supporting analyses and rationale; and
• Include a systematic and logical method to consolidate the loss estimates and ensure the loan loss allowance balance is recorded in accordance with GAAP.

A methodology for allowance for loan losses should be both systematic, properly designed and implemented and should reflect management’s best estimate of its allowance for loan losses. An important aspect of this methodology would include a well-defined loan review process that is consistently applied, identifies differing risk characteristics and loan quality problems accurately and performed in a timely manner.

In practice, banks may employ a number of procedures in order to validate the reasonableness of their loan loss allowance methodology and determine if deficiencies exist in their overall methodology or loan grading process. Some examples include:

• A review of trends in loan volume, delinquencies, restructurings, and concentrations.
• A review of previous charge-off and recovery history, including an evaluation of the timeliness of the entries to record both the charge-offs and the recoveries as well as how these charge-offs coincided with previous estimates.
• Reviews by third parties independent of loan loss allowance estimation processes. This often involves an independent party reviewing, on a test basis, source documents and underlying assumptions to determine that the established methodology develops reasonable loss estimates.
• An evaluation of the appraisal process of the underlying collateral accomplished through periodic comparison of the appraised value to the actual sales price on selected properties sold.

For more information on selected loan loss allowance methodology and documentation issues refer to www.sec.gov/interps/account/sab102.htm.

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